Here are a few key practical problems that can arise when using discounted cash flow valuation models: - Forecasting cash flows accurately over a long time horizon is very difficult due to uncertainty. Small changes in assumptions can significantly impact the valuation. - Determining the appropriate discount rate (WACC) requires estimating input parameters that are not directly observable like the equity risk premium. Reasonable analysts can disagree on the discount rate. - Valuations are highly sensitive to the terminal value, which comprises most of the value. The terminal value is calculated using perpetual growth assumptions that may not reflect reality. - DCF models do not account well for flexibility, optionality, or other strategic considerations. The value created by real options is

1. Basics of Valuation
Unit Two- 6 hours

2. Valuation
 When valuing a company, it’s important to distinguish between
the Enterprise Value or Firm Value and Equity Value.
 The Enterprise Value or Firm value is the value of the entire business
without taking its capital structure into account.
 Equity Value is the value attributable to shareholders, which includes any
excess cash and exclude all debt and financial obligations.
 The type of value you’re trying to arrive at will determine which cash flow
metric you should use.
 Use FCFE to calculate the net present value (NPV) of equity.
 Use FCFF to calculate the net present value (NPV) of the enterprise

3. Types of cash flow
 Cash from Operating Activities – Cash that is generated by a company’s
core business activities – does not include CF from investing. This is found
on the company’s Statement of Cash Flows
 Net Change in Cash – The change in the amount of cash flow from one
accounting period to the next. This is found at the bottom of the Cash Flow
Statement.
 Free Cash Flow to Equity (FCFE) – FCFE represents the cash that’s
available after reinvestment back into the business (capital expenditures).
 Free Cash Flow to the Firm (FCFF) – This is a measure that assumes a
company has no leverage (debt). It is used in financial modeling and
valuation.

4. Free Cash Flow to Equity (FCFE)
 Free cash flow to equity (FCFE) is the amount of cash a business
generates that is available to be potentially distributed
to shareholders.
 FCFE = Cash from Operating Activities – Capital Expenditures + Net
Debt Issued (Repaid)

5. Unlevered free cash flow or FCFF
 Unlevered Free Cash Flow (also known as Free Cash Flow to the Firm or FCFF
for short) is a theoretical cash flow figure for a business.
 It is the cash flow available to all equity holders and debt holders after all
operating expenses, capital expenditures, and investments in working capital
have been made.
 It is technically the cash flow that equity holders and debt holders would have
access to from business operations.
 Unlevered free cash flow is used to remove the impact of capital structure on a
firm’s value and to make companies more comparable.
 By using unlevered cash flow, the enterprise value is determined, which can
easily be compared to the enterprise value of another business.

6. FCFF
 FCFF = Net Income + Depreciation-Capital Expenditure –
Increase in Non Cash Working Capital
+ Interest *( 1- Tax rate)
 FCFF = Cash flow from operating Activities +
Interest *( 1- Tax rate) – Capital Expenditure
 Unlevered free cash flow = EBIT – Taxes + Depreciation &
Amortization – Capital Expenditures – increases in non-cash
working capital

7. Equity Valuation
Equity value, commonly referred to as the market
value of equity or market capitalization, can be
defined as the total value of the company that is
attributable to equity investors.
It is calculated by multiplying a company’s share
price by its number of shares outstanding.
Equity value = enterprise value- debt and debt
equivalents- non-controlling interest and preferred
stock+ cash and cash equivalents.

8. Discounted Cash-Flow Valuation
 Discounted Cash Flow (DCF) analysis is an intrinsic value approach where an
analyst forecasts the business’ unlevered free cash flow into the future and
discounts it back to today at the firm’s Weighted Average Cost of Captial (WACC).
 The intrinsic value of a business (or any investment security) is the present value
of all expected future cash flows, discounted at the appropriate discount rate.
 Every asset has an intrinsic value that can be estimated, based upon its
characteristics in terms of cash flows, growth and risk
 Information Needed: To use discounted cash flow valuation, you need
 to estimate the life of the asset
 to estimate the cash flows during the life of the asset
 to estimate the discount rate to apply to these cash flows to get
present value

9. Dividend Discount Model
 A model that determines the current price of a stock as it dividend next
period divided by the discount rate less the dividend growth rate
 Growth model
Zero growth
Do=D1=D2=D3= constant
Constant growth
D1= D0 * (1+g)
Supernormal growth

10. Free Cash Flow to Equity (FCFE) Valuation
Model
 The value of equity is obtained by discounting expected cash flows to equity
(levered cash flow), i.e., the residual cash flows after meeting all expenses, tax
obligations and interest and principal payments, at the cost of equity, i.e., the
rate of return required by equity investors in the firm.
where,
CF to Equityt = Expected Cash flow to Equity in period t (levered)
re= Cost of Equity for levered firm
 Forms: The dividend discount model is a specialized case of equity valuation,
and the value of a stock is the present value of expected future dividends.
 In the more general version, you can consider: FCFF-Interest and debt
payment

n
=
t
1
=
t
t
e
t
)
r
+
(1
Equity
to
CF
=
Equity
of
Value

11. Free Cash Flow to the Firm (FCFF) Valuation
Model
 Unlevered cash flow discounted at the rate of WACC
 Value of the firm includes value of debt and equity Because,
Its value of the Firm
 For value of the equity, value of the debt must be deducted.
 FCFF works best for company that have large debt
 Estimates project’s value by discounting unlevered cash flows
using constant WACC

12. Discuss practical problem